This post may contain affiliate links. Please read my disclaimer for more information.
Thinking in Percentages
Apples and Oranges, and Aluminum Cans
What if I told you I paid $1,200 per month on rent? Some of you are thinking "that's an expensive place to live" and others are thinking "that's a steal!"
What if that were changed to $1,200 per month on a mortgage? How might your opinion change if that cost was for a 1-bedroom / 1-bath vs. a 3-bedroom / 2.5 bath with an acre of farmland? Would $2,000 be a more-appropriate number?
The point is, dollars are highly subjective. Costs in New York City are not the same as in Fish Creek, Wisconsin (which is apparently one of the nicest small towns in the Midwest). Reflecting on my budget in dollars is only completely applicable to...me.
Not only that, but the line items and the amounts spent on those items means something much different if you are making $30,000, $100,000, or $500,000 per year. What we spend $100 on may seem like burning money to one person, and a highly frugal exercise to another.
The great equalizer? Percentages. Specifically, percentage of gross income.
A Gross Assessment
Why choose gross income instead of net? Gross is used for two reasons:
Let's look at each of these in turn.
Taxes Are Still Expenses
Take-home pay, or net pay, is the income number most individuals are concerned with. After all, this is the amount that goes into our bank account. This is the fuel that supports our everyday spending, goals, splurges, emergencies, and other expenses.
Yet taxes represent one of the highest drains on our overall worth. According to a 2015 article by Nerdwallet, How Much Do Americans Really Pay in Taxes?,
27% is a massive amount of spending. And even with the tax cuts this year, income taxes are still a major expense. They should not be ignored.
Comparing All Expenses vs. Net Does Not Make Sense
Mathematically that is.
Comparing all expenses, including income taxes to a revenue value after taxes would result in a number larger than 100%.
And taxes are not the only expense taken before you get your paycheck. If your company offers a 401k or you participate in other pre-tax retirement accounts, this money is taken off the top.
At best, comparing to an after-tax number simply does not make sense. At worst, it may lead you to disregard taxes altogether. You may think that you do not have control over your taxes, but you would be wrong.
Contributing more to pre-tax buckets such as a 401k reduces your taxable income, decreasing income taxes. Yes, take-home pay is ultimately lower, but giving up $80 in net pay for $100 applied to a retirement account is basically pulling money out of thin air. You just became a magician, and you didn't even have to saw a lady in half.
Reviewing the Budget
Another benefit of reporting in percentages is understanding the relative burden these expenses represent. Only you can understand how $1,200 per month for a mortgage feels, but 10% of gross income is universal.
Here is the breakdown from a previous article, Budget Review: August 2018:
Let's investigate two cases:
I will drop the 0% categories above for the analysis.
Situation 1 ($50,400 per Year) - monthly costs are as follows:
Situation 2 ($114,000 per Year) - monthly costs are as follows:
These two breakdowns look completely different, but each may be lavish, frugal, or just about right depending on where you live and your personal situation.
That is why dollars mean less - they require context and explanation to provide useful information. Percentages lead to a more-realistic understanding of where you are spending income.
Don't let dollars lie to you. Converting everything to percentage is a way to normalize your spending and better understand the effect on your overall cash flow.
Do you agree that percentages are a better way of looking at expenses or do you think cash is king? When you plug in your gross income, do any of my numbers above seem excessive or impossibly low? Comment below and let me know!